Premium misclassification or payroll misclassification is a significant issue for the workers’ compensation industry, according to Bret Shroyer, a solutions architect for Denver, Colo.-based Valen Analytics.

Shroyer estimates that roughly $22 billion of payroll is misclassified each year, and the aggregate impact to the insurance industry is in the range of $1.6 billion in workers’ compensation premiums.

The situation is worse in California, which accounts for roughly one-third of the nationwide total of misclassified payroll.

Shroyer spoke with Insurance Journal about this issue and how it affects the insurance industry and insureds.

Insurance Journal: What percentage of premium is misclassified on average every year, in California, nationwide?

Shroyer: For the industry as a whole, that number actually isn’t very large. It’s only about 2.5 percent of aggregate payroll that’s misclassified, but the payroll that is misclassified can be anywhere between 8 percent to even 15 percent of the account when that happens. The impact on the final premium is significant. It can be as much as 20, 30 percent.

For California, it’s about 12 percent of the payroll is misclassified in terms of the number of accounts that have misclassified payroll. That accounts for about 100,000, one-third of the nationwide total. The impact in California is also about one-third of the nationwide total. Almost $500 million of workers’ compensation premium results from that misclassified payroll.

Insurance Journal: Is California an outlier, or is it just because it’s the biggest state in the U.S.?

Shroyer: California’s definitely the biggest state in terms of the comp market, but it also has a much higher than average incidence rate of misclassified payroll, almost 50 percent higher than the national average. The impact when payroll is misclassified is also much larger.

Insurance Journal: In what industries does this occur most?

Shroyer: The construction industry is the clear winner in this category. It’s got a misclassification rate that’s just a little higher than the national average in terms of percent of policies, but it has a huge impact on the premium that’s charged. It’s almost half of the industry total, $500 million of misclassification on the workers’ compensation premium.

Insurance Journal: What’s driving misclassification?

Shroyer: Misclassification, in a way, it’s hard to detect because you’re looking at pre- and post-audit payrolls, and pre- and post-audit premium amounts. There’s always going to be some change just due to economic growth if the payrolls are increasing because payroll’s are increasing because the company’s growing.

What we look at is where the distribution of payroll by class is changing. At the inception, you’ve got a lot of clerical exposure. At the audit, you’ve got a lot of carpentry exposure. There’s clearly a misclassification there.

Some of the things that can cause that to happen are improper or incomplete information that’s put on the application, or a data entry error by the carrier, or it could be deliberate fraud on the part of the insured or on the part of the agent.

Insurance Journal: What’s the impact of misclassification on agents and brokers? Why do they need to know about this?

Shroyer: Agents and brokers, first and foremost, they’re in the customer service business. They’re always trying to get the best deals possible for their insureds. If they’re getting the best deal possible but that’s going to evaporate at the policy termination because an audit results in 20 or 30 percent additional premiums, that does not look good from a customer service perspective.

It’s also terrible customer service if you wind up having a painful audit. You got a bad audit that comes around. It’s contentious. The policyholder’s going to know that, and they’re not going to appreciate that service.